More than two-thirds of the $25 trillion of financial
assets held in the United States is managed on behalf
of investors by financial intermediaries, ranging from
trusts, mutual funds, and mortgage pools to insurance
companies, pension funds, and banks. Because of their
importance, governments have long regulated the activities
of these intermediaries to ensure sound financial markets,
a foundation of secure economic development. Currently,
regulators both here and abroad are considering reforms
that not only might foster more efficient domestic financial
markets, but also might prepare the way for more equitable
global markets.

When not all investors are fully informed about the
prospective returns on all assets, the cost of funds
for financial intermediaries depends on savers' state
of confidence in their investments. Because the regulations
that govern intermediaries affect the price of risk
in financial markets and because this influence varies
with economic conditions, the actions of regulators,
like those of the monetary authority, may need to adjust
with economic conditions in order to foster the prudent
valuation of assets. The prompt enforcement of fixed,
risk-based capital requirements, for example, might
diminish the ability of financial intermediaries to
cope with economic shocks. Because capital ratios measure
neither the insurance inherent in intermediaries' balance
sheets nor the capacity of this insurance to contend
with different risks, more revealing assessments of
the safety and soundness of intermediaries should consider
how their earnings and cash flows might change with
economic conditions.